In this special presentation, get the answers to key questions about the quality of your plan, whether your savings are on track with your goals, how to allocate assets, and what to do with assets when you leave your job.

ABCs of Alternative Investing

Alpha measures the difference between a fund's returns above its benchmark risk exposure(s) (as measured by beta). A positive alpha figure indicates the fund has performed better than its beta would predict. In contrast, a negative alpha indicates underperformance. When selecting alternative products, investors should look at alpha to measure the value added or subtracted by a fund's manager. Alpha should be considered relative to both standard and alternative benchmarks (such as the Morningstar Long/Short Commodity Index, Morningstar Diversified Futures Index, or the Morningstar MSCI Hedge Fund Indexes.)

Beta measures a fund's sensitivity to market movements. By definition, the beta of a particular market (represented by an index) is 1.00. A beta of 1.10 means that, on average, the fund performed 10% better than its benchmark index in up markets and 10% worse in down markets, assuming all other factors remain constant. Conversely, a beta of 0.85 indicates that the fund gained 15% less than the market during an upturn and lost 15% less during down markets. Certain alternative strategies, such as long/short equity or multialternative, maintain higher equity beta exposure (between 0.30 and 0.80), while most market-neutral funds maintain betas to the S&P 500 Index of between negative 0.3 and 0.3.

Cash collateral can account for 75% of a managed-futures fund's portfolio. Because futures contracts require relatively low initial margins (as low as 5% for 100% exposure, for example), the majority of a managed-futures fund's assets are reserved for collateral. Historically, managed-futures strategies earned decent returns simply by holding Treasuries, but this is no longer the case. In response, some funds have hired outside advisors to invest this cash collateral, taking on credit and duration risks. Some managers take on more risk than others, investing in nonagency mortgage securities, asset-backed securities, 144A restricted securities, master limited partnerships, or even real estate investment trusts. When selecting a managed-futures fund, investors should carefully consider how the cash collateral is managed and if the strategy fits their risk tolerance.

Drawdown refers to an investment's peak-to-trough decline during a specific time period. Investors should analyze a fund's drawdown patterns, particularly its maximum drawdown since inception, to more fully understand its investment risks. Although most liquid alternative products launched after the financial crisis, investors can analyze how these younger funds held up during more recent episodes of volatility (the May 2010 "Flash Crash," or the period from April 26 to July 5, for example) as a proxy.

An expense ratio is the annual operating fee a fund's shareholders must pay. It expresses the percentage of assets deducted each fiscal year for a fund's operating expenses, including 12b-1 fees, management fees, and administrative fees. Transaction fees or brokerage costs, as well as initial or deferred sales charges, are not included in the expense ratio, with the exception of borrowing costs for short positions. Therefore, for alternative funds, its best to look at the net expense ratios, which net out shorting costs. Even after taking into account the cost of shorting, alternative mutual funds tend to have higher expense ratios than long-only strategies for two reasons. First, many alternative products are relatively small (60% of alternative mutual funds manage less than $100 million). Second, these funds often have higher management fees due to their more sophisticated research, trading, and risk management.

Funds of funds specialize in buying shares in other mutual funds rather than individual securities. Most alternative funds of funds reside in the multialternative category, though there are a handful in the other categories as well. There are several advantages to the fund-of-funds approach: namely, convenience, ease of use, and additional layers of due diligence. With a one-stop-shop product, investors no longer need to select managers and strategies themselves. The trade-off is that the expense ratios are very high--sometimes above 3.00%. When analyzing funds of funds, investors must be careful to look at the prospectus expense ratio, rather than the annual report figure, because it includes the acquired fund fees paid to the fund's underlying mutual funds or exchange-traded funds. Investors should also be careful to avoid multimanager products that include allocations to more traditional investments, such as publicly traded REITS or long-only commodity strategies. Investors can gain exposure to these long-only asset classes for a much lower price outside of the funds of funds.

Global Macro funds invest across asset classes (that is, stocks, bonds, currencies and commodities) both long and short based on macroeconomic trends. The approach typically involves a medium-term (several-month) holding period and produces high volatility. Many of the industry's largest hedge fund firms, such as Soros Fund Management and Bridgewater Associates, run global macro strategies. As of May 31, 2012, Morningstar's Global Macro hedge fund category included 236 funds that collectively managed $54.8 billion. Very few mutual funds or ETFs currently employ this strategy.

Hedge funds were the original alternative investment. Alfred Winslow Jones established the first hedge fund in 1949, a private partnership with a 20% incentive fee. Jones' fund was the first to employ an equity market-neutral strategy, and its wild success was documented in a 1966 Fortune magazine article. Following that, these private, illiquid vehicles proliferated, and the term "hedge fund" became synonymous with "alternative." Now, however, most alternative strategies are available to all kinds of investors in public, regulated, liquid structures such as mutual funds (under the Investment Company Act of 1940) and exchange-traded-funds.

A fund's inception date is the day on which it starts trading. Most liquid alternative investments are relatively young--less than half of the 324 alternative mutual funds in existence have a three-year track record. To analyze these newer products, investors should consider track records of similar hedge funds or separate accounts run by the same manager.

Junk bonds, also known as high-yield bonds, are bonds with a credit rating of BB or lower. Junk bonds are typically issued by companies without long track records of earnings or a strong credit history. Some alternative funds that invest in high-yield bonds, particularly in the nontraditional bond category, hedge the credit risk associated with these riskier investments using credit default swaps.

Excess Kurtosis is a statistical term used to describe the peakedness of a return distribution relative to a normal distribution. Higher kurtosis (leptokurtosis) means that the distribution has fatter tails than a normal distribution, and therefore greater exposure to outlier events. Combined with negative skewness, this translates to considerable downside risk. Historically, convertible arbitrage strategies have exhibited higher excess kurtosis than any other hedge fund strategy due to their credit, liquidity, and event risk.

Leverage and liquidity levels for alternative mutual funds are mandated by the Investment Company Act of 1940. According to this legislation, shorts or other future obligations to pay must be covered. Shorts and leverage are governed under "senior securities" rules, which require a minimum asset coverage (after including short proceeds) of 300% of the amount borrowed. Liquidity rules call for at least 85% of a fund's assets to be invested in liquid securities, those which can be sold within seven days at approximately the last valuation.

Manager ownership refers to a portfolio manager's level of personal investment in his or her fund. For U.S. fund firms, this information must be disclosed annually to the SEC in the Statement of Additional Information. Fund managers who invest in the funds they run demonstrate conviction in their investment process and align their own financial interests with those of fund shareholders. Some alternative fund managers, such as TFS Capital Funds, mandate manager ownership.

Net equity exposure is defined as the dollar value of long positions (gross long exposure) in a portfolio less the value of short positions (gross short exposure) as a percentage of the total assets in the fund. A more sophisticated measure of net exposure involves calculating the delta, or beta-adjusted exposure, of the long and short securities relative to the stock market. Net exposure levels vary widely across alternative strategies. Market-neutral offerings, for example, tend to take offsetting long and short equity positions with the intent of hedging out most or all broad market risk. Long/short equity funds, on the other hand, will vary widely in exposure level depending on the manager's outlook but will rarely have more than 80% net equity exposure.

An option is the right--but not the obligation--to buy or sell a specified amount of security at a specified price within a specified time frame. For example, a put option gives the holder the right to sell a security, and a call option gives the right to buy the security. Alternative managers, such as Patrick Rogers of Gateway GATEX, often use long index put options to hedge downside risk. If the put option's underlying security experiences losses beyond the strike price, the manager has the right to put it to somebody else, thereby avoiding significant losses.

Performance fees, or incentive fees, may be paid to portfolio managers who generate positive returns. The general rationale for incentive fees is that they help to align the interests of fund managers with those of their investors. However, many argue that they also encourage managers to take excessive risk, because managers share in the profits but are not affected by losses. Performance fees are most closely associated with hedge funds, through their infamous "2 and 20" compensation structure. Most mutual funds cannot charge performance fees--the one exception being funds in the managed-futures category. For tax purposes (mutual funds cannot derive more than 10% of their income from commodities), these funds execute their futures trades in a controlled foreign corporation, which is not currently regulated by the SEC and can therefore charge performance fees. The double layer of management fees plus the performance fees can make these products very expensive, often charging more than 4.00%.

It's no secret that hedge funds have strict eligibility requirements. For example, only qualified purchasers (investors with at least $5 million in investment assets or companies with at least $25 million in investment assets) can invest in 3(c)7 hedge funds. (Most hedge funds, such as 3(c)1 structures, require only accredited investor status, net worth above $1 million.) Because of these stricter requirements, most 3(c)7 hedge funds also tend to have greater initial investment minimums and larger asset bases, and are more often marketed toward institutional investors. In contrast, thanks to the recent "democratization" of alternatives, any investor can access an alternative mutual fund or exchange-traded fund.

When analyzing alternative products, investors should look at risk-adjusted returns, which show how much money a fund makes relative to the amount of risk it took on over a specific time period. One of the most popular risk-adjusted return measures is the Sharpe ratio, which is calculated by dividing a fund's annualized excess returns over the risk-free rate by its annualized standard deviation. Investors can use the Sharpe ratio to directly compare how much risk different funds took on to produce excess returns. Higher positive Sharpe ratios mean better historical risk-adjusted performance. The Sortino ratio, a variation of the Sharpe ratio, differentiates harmful volatility from total risk (standard deviation) by using a form of downside deviation in the denominator.

Short sales are sales of a security that the seller does not own. This is a speculative form of trading where the seller believes that the price of a security is going to fall and that they will be able to cover the sale by buying back the security at a lower price. Short-selling can be much riskier than long-only investing because a losing short position becomes a larger part of the portfolio than a losing long position (which can only go to zero). Short sellers must also pay dividends and coupons on shorted stocks or bonds. Because of these risks, investors should look specifically for a proven short-seller with significant shorting experience when selecting a long/short equity fund.

Turnover refers to how often a fund sells all of its holdings in a given year. If a fund has a 100% turnover rate, that means the fund manager, in theory, has sold every single position once. High turnover rates mean more transaction costs and therefore lower tax efficiency. So high-turnover funds are best held in a tax-advantaged account, such as an IRA.

A fund's upside/downside capture ratio shows whether it has outperformed--gained more or lost less than--a broad market benchmark during periods of market strength and weakness, and if so, by how much. Upside capture ratios for funds are calculated by taking the fund's monthly return during months when the benchmark had a positive return and dividing it by the benchmark return during that same month. Downside capture ratios are calculated by taking the fund's monthly return during the periods of negative benchmark performance and dividing it by the benchmark return. In general, alternative funds have upside and downside capture ratios below 100%--investors are sacrificing some of the upside so as to avoid some or most of the equity market's downside.

Volatility is often used synonymously with standard deviation, a statistical measure of the dispersion of returns around the mean return for a given security or market index, assuming a normal distribution. In general, the higher the volatility, the riskier the investment. Incorporating alternative investments into a long-only portfolio will generally help to reduce a portfolio's overall volatility if the alternative strategy exhibits a low correlation to the existing investments.

A whipsaw occurs when a security's price heads in one direction but then is followed quickly by a movement in the opposite direction. These types of market movements can spell disaster for managed-futures strategies, which seek to profit from price trends or momentum across various asset classes. In the worst-case scenario, the manager (or in most cases a computer model) identifies the trend too late, just before it reverses. By the time the program switches its position (from long to short, for example), it may again be on the wrong side of the trend (because the market has started going up again, for example). Managed-futures returns were poor in 2009 and 2011 due to this phenomenon.

X-correlation, or cross-correlation, refers to the relative movement between two or more series of returns and is measured on a scale of negative 1 to 1. When constructing a diversified portfolio, investors should seek to combine a number of noncorrelating strategies (with positive risk-adjusted returns). Of all liquid alternative strategies, managed-futures funds have exhibited the greatest historical correlation benefits--the category average's three-year correlation to the S&P 500 index is a mere 0.28. Market-neutral offerings can also enhance diversification (the category average's three-year correlation to the S&P 500 index is 0.33), while long/short equity and multialternative funds typically exhibit correlations well above 0.90.

The yield curve shows the relationship between yields and maturity dates for a set of similar bonds at a given point in time. Though rates have reached rock-bottom in recent years, interest-rate risk remains a big concern for investors. Looking at flows over the past decade, investors have allocated record amounts to bond funds over the past few years (over $360 billion in 2009, $230 billion in 2010, and just over $120 billion last year). These massive inflows may be subsiding, but it's clear many investors are faced with bond-heavy portfolios. Many funds in the newly created nontraditional bond category hedge against duration risk and may therefore provide fixed-income diversification.

Last but not least, a good alternative investment will zig when traditional stock and bond markets zag. That's because these products invest in different asset classes (commodities or currencies) or employ nontraditional trading strategies (shorting and hedging). As a result, they should produce a very different, uncorrelated return profile from long-only equity or bond investments.